A New Angle on the Impact of Quantitative Easing on Interest Rates

06/14/2013

A paper by Johnson’s Professor Robert Jarrow and PhD candidate Hao Li won the best paper award at 2013 Fixed Income Conference.

A paper co-authored by Robert Jarrow, Ronald P. & Susan E. Lynch Professor of Investment Management and professor of finance, and Hao Li, a fifth-year PhD student in finance, won the Arthur Warga Best Paper Award at the Darla Moore School of Business 2013 Fixed Income Conference, held on April 19 and 20 at the University of South Carolina. The theme of this year’s conference was Looking Beyond Liquidity: Return Enhancement Strategies, Sovereign Debt Threat, and Corporate Credit Risk.

The paper, titled The Impact of Quantitative Easing on the U.S. Term Structure of Interest Rates, “estimates the impact of the Federal Reserve’s 2008–2011 quantitative easing (QE) program on the U.S. term structure of interest rates.” It shows that the QE program reduced short-to medium-term (less than 12 years) forward rates, but had little impact on long-term forward rates. The paper also shows that the Fed’s QE program did not introduce arbitrage opportunities into the Treasury security markets.

“In this paper, we decompose the observed forward rate into two components: unobserved true forward rate if Fed didn’t conduct the QE and the price impact of the QE,” says Li.

According to Li, the conclusion of this paper is helpful to investment managers in the following two ways:

1. By decomposing the forward rate, “one can get a picture about how the treasury yield curve is affected by the QE. Investors, especially bond investors, can therefore prepare for the scenario when the Federal Reserve starts tapering.”

2. The model is helpful in pricing interest rate derivatives in today’s special environment.

The paper also contributes to the existing literature in the following three ways:

1. It estimates the QE’s impact on forward rate instead of bond yield.

“Bond yield is the average of forward rate over bond maturity; it is possible that the QE affects long term yield, but only affects short term forward rate. That’s one thing investment managers need to think about,” says Li.

2. The paper tests whether Fed QE introduced arbitrage opportunities into the Treasury security market and shows that the answer is no.

3. The paper provides a new methodology for estimating the QE’s impact using an arbitrage-free term structure model, thereby enabling researchers to estimate both the magnitude and the duration of the impact.

When asked what contributed to the paper’s success at the conference, Li said, “We were lucky to have a paper that is very topical. It directly addresses the current issue: the impact of the Fed’s QE program, which is one of the most important factors affecting today’s financial market.”